Security Token Offering vs. Venture Capital Raise

For many years startups raised venture capital to fund development, sales and growth of their companies. A tiered investment in company’s equity long considered the traditional way of leveraging risk and maximizing investment returns for both VC funds and startups. The main philosophy of this staged approach was “raise only money you need at this stage”. A typical company might go through 5–6 rounds of funding before exist, if all goes well — all of them with increasing valuation and staged dilution of the founding team. For example, a seed round of $500K might give investors 15–20% of the company’s equity, then round A with $2M in investment would take further 20% and so forth until the company reaches profitability and liquidity with founding team owning 20–30% of the equity, if they are lucky. The process usually takes 5–10 years during which both the investors and the founders are not able to cash out. According to VentureBeat, median time from first funding to IPO for us companies reached 8.2 years in 2017 and 5 years from funding to acquisition. This cycle had a profound impact of the venture fund lifecycle, forcing GPs raise long term capital, locked in the fund for 10 years. On the other hand, considering that most startups fail, this reduced exposure of the funds to smaller amounts, as most failures happen at the early stage.

Boom in ICO market in 2017 gave startup founders a different options for fundraising and all together during that year ICOs raised $5.6B for their companies. Predictably, however, regulators started cracking down on ICOs and utility token sales, deeming them unlicensed security sales. For example since end of last year SEC has sent our dozens of suphoena notices and just last week announced a settlement with two companies that forces them to pay $250K fine and return money to investors. For prudent startup founders raising money this way is no longer an option and the industry set out looking for other options.

Fortunately, latest advances in blockchain and cryptocurrency brought with it a new fundraising phenomenon — security token offering. Such offerings issue tokens as security, complying with regulations governing private capital raises, similar to venture capital raise. However, security tokens can be used not only by blockchain startups, but by any startup that is looking to raise capital for growth as such security token can represent a share of startup’s future cash flows from operations or even regular equity. Unlike venture capital raise, an STO usually deals with minting and offering the entire supply of security tokens, known as “hard cap”, with certain minimum to be sold, “soft cap”. A typical STO structure will set a price for the token offered with some “early bird” discounts ranging from 20 to 50% of the STO price, to entice initial investors. This would be quite different from a steady price growth usually seen in a venture raise, where share price grows many times during the life cycle of the startup. (give example of Uber’s share price growth).

On the surface, investing in STO bears significantly more risk for the investor. Indeed, the price discount for early investor is insignificant to compensate for the risk taken by them putting substantial amount into tokens of a new venture. However, it is important to keep in mind that traditional venture capital invested into illiquid stock of the company, is usually bound by sale restrictions, tag along clauses and right of first refusal, and is frequently complicated by tiered preferred stock structures, liquidation preferences and other toxic terms, substantially reducing options for partial exit to stock holders. This obviously increases risk and forces investors looking for “unicorns” and investing at later stages, where risk is more assured.

As opposed to these complexities, security tokens offer a clean and transparent structure of liquidation, typically with a much shorter horizon. For example, SEC regulations require such security to be held 12 month for US investors and 90 days for foreign ones. After that trading between accredited investors can commence on a crypto exchange, bringing market transparency and liquidity to the token and its pricing.

Security tokens also give the project team an opportunity to focus on their business much more — tiered fundraising requires constant fundraising activity, taking management teams focus away from growing their business. In STO, on the other hand, the entire amount required to grow the business is usually raised in the first sale, leaving founders free to focus on product development, sales and marketing, which in turn will make a direct impact on the token price and liquidity.

Problem of investing significant capital into unproven ventures can in theory be mitigated by controls on capital spending and buyback requirements to return money to token holders if certain milestones are not met. This way even though the proceeds from the token sale are placed with the company, investors have ability to recoup part of their investment in case startup idea does not fly.

Short liquidity will also be the game changer in venture capital fund structure. It is quite possible that a new type of venture fund will appear — one that has substantially shorter life cycle, may be even tokenized itself, linking its own tokens to tokens of its portfolio companies, providing LPs immediate liquidity of their holding and substantially widening the fundraising base for these funds. Venture capital industry stands at a disruption point and it is not surprising that many venerable VCs are creating blockchain and crypto focused funds and exploring new opportunities in security token sales. For example, Andreessen Horowitz, on of the most known Silicon Valley VCs had created a $300M fund a16z Crypto, investing in security token compliance platform Harbor. Seems that STO fundraising is looking at a promising 2019.

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